Fed set to raise interest rates by a half point and shrink balance sheet
Market reaction will depend mostly on Powell’s tone - sell the news?
FX market quiet, stocks lick their wounds, oil smiles at new sanctions
Fed will struggle to exceed market pricing
The Federal Reserve is almost certain to raise interest rates by half a percentage point today and outline plans for shrinking its gigantic balance sheet in an attempt to rein in inflationary forces. Markets have already fully priced in the half-point rate hike and similar moves are baked in for the next three meetings, which would bring the Federal funds rate to around 2.4% by September.
Fed officials have been talking a big game lately, making it clear they won’t wait any longer for the supply side to heal and will instead attempt to cool down demand, particularly in the sizzling housing market. They hope to achieve a soft landing, whereby they manage to tame inflation without sparking a recession.
It won’t be easy for Powell and his colleagues to surpass market expectations. The bar has been set quite high with more than 200 basis points of rate hikes priced in by September. Going any faster than this could snap something - whether it’s the bond market, housing market, or a stock market swimming in leverage. The Fed wants to avoid panic.
There are other reasons to be cautious as well. Several indicators suggest economic growth is losing steam, financial conditions have tightened rapidly, inflation expectations have stabilized, and the appreciating dollar will serve as a weapon in the fight against inflation.
Sell the news?
Bearing everything in mind, there is no great urgency for Powell to ‘go to war’ against animal spirits at this meeting. Instead it makes more sense to strike a balanced tone, highlighting the concerns about inflation but also emphasizing the risks around growth, especially with Europe and China stalling too.
This might disappoint some US dollar bulls who expect Powell to be super-hawkish today, in which case the greenback might finally take a step back. That said, this is likely to be a counter-trend move and the overall picture remains positive.
The dollar became king by riding a perfect wave of rising US rates, risk aversion, and slowing growth in other major regions. An energy crisis has brought Europe to its knees, Chinese authorities remain committed to strict lockdowns, and the Bank of Japan is trying to swim against the tide. Until these dynamics begin to change, it’s difficult to envision a trend reversal in the dollar.
Stocks bounce, oil cheers new sanctions
There wasn’t much movement in the broader FX market, with most pairs closing the session around their opening levels as traders waited for the FOMC meeting to provide some clarity before taking new positions.
Stock markets were livelier. The S&P 500 closed higher by almost 0.5%, probably as investors covered some short bets ahead of the Fed. The bar for a hawkish surprise today is quite high and if Powell simply strikes a neutral tone, that could come as a relief for the bruised equity market, especially for beaten-down tech shares.
Meanwhile, energy is back in the spotlight after the European Union announced a ban on Russian oil that will be phased out over six months. Oil prices spiked higher, although it’s debatable whether this changes much on a global level. Several reports suggest China is ‘stealth buying’ Russian oil at steep discounts, so is this ultimately just an energy subsidy from Europe to China?
Ahead of the Fed decision, the US ADP employment report and the ISM services PMI for April will be closely scrutinized for any clues around Friday’s nonfarm payrolls print.